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Debunking Dividend Myths: Part 4

This post is the fourth in a series exploring the myths and misunderstandings about dividend investing. The goal of the series is to argue that many investors following a dividend-focused strategy may be better off with broad-based index funds.

Dividend Myth #4: You can beat the market with common sense: just focus on blue-chip companies with a competitive advantage and a history of paying dividends.

I recently attended an investment show where one of the speakers (a well-known Canadian author) explained that his strategy was just common sense. It went something like this: “Think about the products and services you use every day. We all use toothpaste, cellphones, debit cards, oil and gas. So all you need to do is identify the best companies in these sectors: they should have strong brand recognition and a competitive advantage. Buy stocks in these companies, and then sit back and watch those dividends roll in.”

Peter Lynch was the pioneer of “buy what you know,” and here in Canada, Derek Foster has taken up the torch. I touched on this kind of folksy investing wisdom in a previous post back in November, after The Globe and Mailprofiled an investor who explained his strategy this way: “I basically sat down and thought, what is absolutely essential to our society, and who provides those essentials?” In his view, it came down to pipelines, banks and railroads, and he chose his stocks accordingly.

Why do these strategies make more sense than simply buying a broad-market index fund? There’s a common-sense answer for that, too: “Buying an index fund is foolish, because you get the bad companies as well as the good ones.”

It’s easy to see why this approach to stock selection is so appealing. It’s intuitive, easy to understand, and empowering. And it makes no sense if your aim is to beat the market.

The problem here is not the premise of the argument—it’s the conclusion. Clearly blue-chip, dividend-paying companies like the big banks, telecoms, major retailers and energy producers are profitable businesses. But this information has zero value to an investor trying to outperform the broad market, for the simple reason that everybody knows this.

Information is not insight

Financial author Larry Swedroe likes to compare stock picking with sports betting. When the first-place New England Patriots play the woeful Denver Broncos, it doesn’t take a genius to identify the favourite. So if you bet on the Patriots, they have to win by, say, 10 points or you lose the wager. Based on all available information — the teams’ records, injured players, home-field advantage — skilled bookmakers establish a point spread that makes the odds of winning the same no matter which side of the bet you take. In other words, knowing that New England is a better team is worthless information.

You can see the parallel with stocks. The “bookmakers” are the analysts who pore over every detail about public companies and trade millions of shares a day. They all know which ones have solid sales, a competitive advantage, a low price-to-earnings ratio and a record of dividend increases, and this knowledge is reflected in the (higher) price of those stocks. Companies and sectors that are struggling are just as easy to identify, and their (lower) stock prices reflect this, too.

In the end, buying Royal Bank or Telus rather than one of their competitors is like betting on the Patriots to beat the Broncos. You’re probably right about which company will succeed in the marketplace. But unless you can consistently cover the spread, you won’t earn higher returns.

The wisdom of the crowds

Common sense is a rare and precious asset, but it has no value when it comes to choosing stocks that will outperform a broad-based index. In an efficient market, every stock’s price already reflects the collective common sense of hundreds of thousands of informed investors. Once you accept this — and it’s clear that many people do not — then it’s wise to abandon the idea of selecting individual companies and simply embrace the market as a whole.

You can put your faith in your own unique ability to outsmart the market, or you can buy a slice of the entire world’s economy for less than 30 basis points. The right choice would seem to be common sense.

Other posts in this series:

Dividend Myth #1: Companies that pay dividends are inherently better investments than those that don’t.

Dividend Myth #2: Dividend investors are successful because they select excellent companies and buy them when they are attractively priced.

Dividend Myth #3: Dividend-paying stocks are a substitute for bonds in an income-oriented portfolio.

Dividend Myth #5: It’s easy to build a well diversified portfolio of Canadian dividend stocks.

Dividend Myth #6: Investors who follow a dividend growth strategy will eventually beat the market on yield alone.

That sure sounds like a Derek Foster quote. Although he left out the “panic” part of his buy dividend stocks, hold said stocks, and panic when the market crashes.

Peter Lynch is a famous proponent of the “buy what you know” stock picking philosophy. But he never said to just find out who made your iPhone and buy that company – he says to look at products and services around you, in order to get investing ideas. You still have to do your research.

I suspect a lot of dividend investors just buy the standard “dividend” companies without much research into the numbers. Not that it would do much good anyway.

But the market is not efficient, nor is it rational. At least not all the time in all sectors. So called skilled analyst are not immune to temporary emotional distortions. I think there is room in one’s portfolio for playing these inefficiencies.

I personally have allocated 5% of my portfolio for these so-called stock picks. My criteria for purchase, is when I am convinced that the market is wrong about the security in question.

PS: I bought some BP back in July of 2010, because I was convinced that the price drop was an overreaction to the graphic reports on various news channels.

Buying a Canadian index fund is foolish, because you get a 50% allocation to volatile resource stocks (27% energy and 23% materials) and then have to balance out all this volatility by buying a Bonds.

A more common sense approach would be build a portfolio that limits sector exposure instead of “embracing the market as a whole”.

It is possible to build a 100% equity portfolio of these common sense dividend paying stocks that has less volatility than your Couch Potato Portfolio. Will it outperform the market? Maybe yes, maybe no. That’s not my goal. I enjoy cash flow. To each their own.

1. The herd is buying dividend stocks
2. That because of “common sense” dividend stocks are priced at a premium

To me there is much more of a premium built into the price of growth stocks because of the herd chasing the latest fads. Just wait and see who buys into these upcoming social media IPO’s to watch the herd at its finest (everyone’s on Facebook so it must be a winner, right?).

It’s not just about buying blue-chip stocks that raise their dividends every year, it’s about the entry point. The market is not perfectly rational (see comment above about BP), so isn’t it possible that by picking up a dividend growth stock trading at only 10 times earnings stands a good chance of outperforming the market over the long term?

@Money Smarts Blog
You forgot the part where Derek Foster spins his panic sell off into a new book claiming he knew what he was doing all along and still made money

@ThinkDividends: Buying only a Canadian index fund definitely exposes you to sector concentration. The volatility can be reduced by investing globally, not just by buying bonds.

@Echo: I can’t argue with the comment about hot growth stocks (these are the worst “common sense stories”), and I agree the market is not perfectly efficient. But large-caps are pretty close. Yes, you can do very well if you always (or usually) get in at favourbale entry points. But this is a lot easier said than done, and it involves spending a lot of timing sitting on cash as you wait. You need to factor that opportunity cost in the calculation if you’re going claim that you beat the market, but no one ever does.

I remember bring up this point with a friend who is a CFA and portfolio manager, and he laughed. He basically said, “Do people really think this stuff is easy? Even analysts get it wrong.” You can’t just look at P/E ratios or other obvious factors and think that’s all there is to it. Because there are countless others out there trying to identify the same bargains, and when they appear they don’t last long.

It strikes me that I should have stressed another point here. What worries me about the “buy what you know” myth is that it’s swallowed hook, line and sinker by unsophisticated investors. People like Think Dividends (a CFA) and many other experienced, educated investors understand this stuff already, and they’re not who I had in mind when I set out to write this series.

The investors I worry about are the ones who buy a Derek Foster book and somehow feel this gives them insight into identifying great stocks. It’s these people who can easily blow up their portfolio with their “hey, this is easy!” overconfidence.

Hi Dan, it seems like we’ve at least found some common ground here regarding growth stocks and Derek Foster. And I also agree about the opportunity cost of having your cash sitting on the sidelines waiting to buy at attractive levels.

After reading a few interviews with Derek Foster at other blogs, it blows me away that people buy into his story. Yes, the basics of what he says makes sense, live within your means, buy blue chip dividend payers and avoid the fees. But that’s not how he got there. What he says and what he does are two different things.

Option trading can be highly sophisticated, and making a huge leveraged bet on one stock is downright insane. Nobody can duplicate his so-called success, but you’re right that people just eat it up. That would be like inheriting $500,000 and investing that money in a bunch of blue chips to live off the dividends, and then writing a book on how dividend investing made you successful. Huh?

@Think Dividends
Yes you have the background, and a sophisticated knowledge and access of the markets that only a few people do. So your strategy is sound and will likely yield you excellent results. If you can beat the benchmarks while collecting dividend income, that is quite ideal. I wish you had a blog we could read, I would enjoy that Drop me an email sometime.

@Couch Potato
Not everyone wants to invest in global equities – I certainly don’t, other than the US, and feel that just adds more risk to my portfolio (not safety). Japan for example – that’s been a deflationary dud for years.

@Everyone
I don’t disagree with anyone’s approcah here. I like the consistent stream of dividend income I recieve – with the potential for Captial Growth. Ultimately it comes down to whether you can beat the benchmark you are investing in – for Canada that is the S&P/TSX Composite Index for stocks.

If the annual dividend yield plus the capital appreciation (or loss) of my dividend stocks (and any other stocks in my portfolio) in any given year, is not beating the benchmark index for that year, then I would have to ask myself what is the point?

Passive Index Investign takes all the guess work out of the equaiton, and allows investors to get started easily and in a more objective way than stock picking, without havign the expereince. Its not that it is a better way to invest, it does have a common sense approch to it – though I also have issues with it as well.

I think what Dan is saying here, is that novice investors are getting caught-up in strategies that are being marketed as easy solutions for them. But may not be so prudent for their circumstanes, becuase they don’t have the understanding of the risks involved, or the basic knowledge of what they are investing in. Again “putting your eggs all in one basket” always gets investors in trouble, which is why I advocate diversification.

@Ninja: Thanks for your thoughts. You raise an interesting point about the simplicity of indexing. To me it makes little sense to encourage someone with no investing knowledge to start buying individual stocks.

If I knew someone who was just starting out and was interested in Canadian dividend stocks, I would suggest they concentrate on saving money every month (the hardest part), and just putting it all into a Canadian index fund for now. Then spend a year or so reading books on dividend investing. I mean good books, like Lowell Miller’s The Single Best Investment, not flim-flam by motivational speakers with dubious back stories.

Then, when you’ve built up some knowledge, if you want to try your hand with individual stocks, go ahead. But don’t cash out of your index fund — that’s your diversifier. Do both, see what you’re comfortable with, and evolve from there.

@Canadian Couch Potato: Now that’s good advice. My biggest concern with new dividend investors is that most people treat it like a sprint not a marathon. It takes decades to see the dividend strategy really play out and most people don’t have the fortitude to endure. For example, if you bought and held CN Rail at the IPO in 1995 your dividend income would have gone up 10 fold, but not too many people can make that claim. CHEERS

@Think Dividends: Actually, a dividend growth investor wouldn’t have purchased CN Rail at the IPO – no track record of dividend growth (yet this stock would no doubt be included in any study indicating dividend growth investing is more effective than investing in the broader market index…).

Regardless if you’re a fan or “not-so-much” of Derek Foster, the reality is this – most investors don’t have the patience nor discipline to hold any established companies (dividend-payers or otherwise) for the long run. To that end, few investors likely accomplished what Think Dividends put in his comments:

“if you bought and held CN Rail at the IPO in 1995 your dividend income would have gone up 10 fold, but not too many people can make that claim.”

I’m fairly new to dividend investing (about 3 years now) and it will be interesting to manage my emotions when Bank of Montreal, CIBC, Sun Life, Enbridge, Bell and other blue-chips eventually take a nose dive (again). I believe I have the discipline to see things through for the long-haul but the real proof will be when the sky is falling and I can push the “buy” button or keep my hands off the “sell” button when equities crash 30%. Regarding your myth, I’m not concerned about beating the market. I’m more concerned about having some tidy passive income in my retirement years that will supplement my existing indexed, broad-sector ETFs. I buy dividend-paying stocks because I too, LOVE cash flow, not because I want Bank of Montreal to beat the pants off the S&P/TSX 60 Index (although that might be an excellent by-product of BMO’s stock). Dividend-investing is not an easy solution. Going all-in with this strategy is simply downright risky, I would never do it personally. When I interviewed Derek Foster in December, I asked him about his investment strategy, his asset allocation and his bond component. Here was his response:

Derek: “I’m 100% stocks, both Canadian and U.S. dividend-paying stocks. I have no bond component. Not that I think bonds are bad, simply, I’m a forty year old Derek Foster and I don’t see why I need bonds right now with my multiple income sources. The empirical evidence is overwhelming about how stocks beat bonds over the long-run, I’m talking 20 or 30 years. I’m working on growing my dividend portfolio over the next 30-some years so this is why I don’t personally follow any conventional bond allocation protocol. Ask the seventy-five year old Derek Foster and he’ll probably give you a different answer about his bond allocation. I’m just not there yet.”

Novice investors would do well Dan, doing the potato dance no doubt. More advanced investors should do whatever they are comfortable with as long as they are ready for the eventual outcomes of their investing actions, Derek Foster or otherwise. We all live and learn. Not every dividend investor is following Derek Foster’s plan to the letter, I would argue some of them are using his journey to learn what they are not comfortable with

You’ve written a superb series of posts here Dan.
In theory, I believe that individual dividend stock investing could be a winner against indexes. But in practice, the vast majority of sophisticated investors will be pounded, over their lifetime, by a basket of broad stock market indexes. Here are the reasons why:
1. If a favourite dividend paying stock has disappointed analysts and made some lousy acquisitions or unfortunately suffered from a tenure of a lousy CEO, the stock is going to become a pariah, perhaps for years. This will happen to virtually every business that exists, at some point. The stock will drastically fall, and no analysts you can find will be painting a rosy picture of the business. If you don’t believe me, then you haven’t been investing long enough.
What will the average individual dividend stock selector do under the above circumstance? He or she will sell and move into something else—probably at the exact time they should be staying put or buying more of their dog stock. It’s tough to stick with a dog for a period that might be years and years, while the market moves on ahead. But often, that’s how to beat the market over the long term. However, most investors–including sophisticated investors—don’t have the guts to do that.
2. When growth stocks swing back in favour (value doesn’t ALWAYS beat growth) most dividend stock pickers will find their stable portfolio is getting pounded by their neighbour’s high cost growth mutual fund. The stock picker might be able to handle that for a year, or three, or five. But after losing more and more ground to a bunch of ridiculously expensive, actively managed growth funds, they’ll capitulate and change investment strategies, probably looking for growth stocks themselves. Their 5% dividend yields will be little consolation when their total returns are falling behind by 50% or more over a ten year period, compared to the average growth fund.
There are people who are wired to select dividend paying stocks and potentially beat the market’s total returns over an investment lifetime. But statistically speaking, I’m not one of them, and the odds are that you aren’t either.
3. People who think they can beat the markets often follow trends, interest rates, economic news etc. And this forces them, at some point, to do something active…to make changes to their portfolios. But my sister, who indexes a balanced portfolio, rebalances every year and knows nothing about the stock markets, will beat the vast majority of sophisticated individual stock investors. Studies show that the more you mess with things, the less you typically make.

4. Because most individual stock pickers think they can beat the market, they will not mechanically dollar cost average (or value average) into a broad basket of dividend paying stocks, come hell or high water. If you were rattled by 2002/2003 and 2008/2009, then I don’t think you have any business buying individual stocks.

If those periods made you feel like an oversexed man in a harem, then you likely have the rare qualities necessary to match the market with your individual stocks. But beat the markets? Some people obviously will. But the odds are low.

Final Thoughts: I personally don’t think indexing is the way to go for the TSX. From the huge Nortel weighting 10 years ago to the excessive resource exposure today the TSX is a poor index in terms of its composition and lack of diversity. This is something that index investor can’t control. That’s why I believe a passively managed diversified portfolio of dividend stocks will reduce volatility. This may or may not be an indexing-beating strategy, but you will have a less bumpy ride since the majority of high quality dividend stocks have low betas (My dividend portfolio had a weighted average beta of 0.6x the last time I checked). On the other hand, I have no qualms about indexing the S&P 500 because of its nice sector diversification and the quality of its largest holdings.

He invests in the two largest (by market cap) companies in 10 different sectors on the TSX.

This is far more work than an index, but it might be better suited for the TSX.

Some drawbacks:

– In an under-represented sector, some of the companies could be fairly small.
– Need a decent size Canadian portfolio to make this worthwhile.
– It would take a lot more than 2 minutes to set up and administer this portfolio.

You’re probably right, but most people won’t sit tight long enough on their stocks. They’ll be swayed to “do something”. For you, it sounds like it would work. But I don’t think it would work for the majority. When looking at a complete Canadian couch potato portfolio split in thirds between the TSX index, the U.S. index and a bond index (rebalanced annually) I’ve very impressed with the low, relative volatility and the high long term returns.

@Andrew: Many thanks for adding your comments. It’s great to hear the perspective of someone who has been both a stock picker and an index investor for many years. As you point out, so much has to do with behaviour, and it’s impossible to predict how you will handle certain situations before you experience them first-hand. Cheers!

@MyOwnAdvisor: Thanks for your insights, too. It’s been great to hear from all the people who use some combination of both strategies. At some point, it’s not about finding the mathematically optimal solution, it’s about finding a strategy that allows you to meet your financial goals and feel comfortable along the way.

Your overall message is to bet on the market rather than bet on individual stocks which i agree with. But you also say index funds are poor because you also get bad companies, but if you broadly invest in the market you are also bound to be investing in some poor companies. One can see index funds as betting on the better performing sections of the market.

Index funds often outperform the overall market, can be less risky, and provide higher returns than individual stocks. Someone that is investing in an index is not required to beat the market or outsmart the thousands of common sense investors. It can be much easier to predict a downturn because of policy, etc which have more impact on the price and can be foreseen.

Are there any other arguments against index funds other than bad companies are included?

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